The Real Estate Development Process: Understanding the Risks and Milestones
Real estate development is a multi-step process that can be complicated, lengthy and risky. It can take years to bring a project from the initial planning stage through construction to final completion, and there are plenty of obstacles that can pop up along the way. Yet development projects also can be highly profitable investment opportunities. By definition, development projects provide the opportunity to deliver a product that does not currently exist into a market, often providing the fresh new supply to satisfy pent up market demand. When executed well, this aspect of a development project can translate into a runaway success story, something that simply isn’t nearly as possible with an existing asset. Investors can more confidently assess some of the risks associated with construction by better understanding the “life cycle” of a development project.
Risk across project type and stage
Two factors can play a big role in the risk of a given project: the project type and stage. As shown in the graph above, the project type can determine the steepness of the risk curve across the project life cycle.
An example of a project type with relatively low risk across all stages of the life cycle is a retail “build-to-suit” project. In a retail build-to-suit, a developer secures a long-term credit tenant, such as a McDonald’s or Walgreens, and develops a property to suit that tenant. For these types of projects, construction risk is low because the buildings are fairly uniform, and leasing risk is almost non-existent because the tenant is already identified and under lease with limited ability to terminate. There may be some pre-development risk depending upon the regulatory hurdles, as described in the Pre-Development section below.
At the opposite end of the spectrum, an example project type with relatively high risk across all stages is called a “speculative” or “spec” project. In a spec industrial or office project, a developer may have few or no leasing commitments before commencing construction. The developer justifies the project by pointing to existing or projected demand for the property after completion. For speculative projects, the leasing risk is high because there are no identified tenants at the outset, the construction risk can be high if the project design is unique, and the pre-development risk can be high if financing is difficult to obtain or regulatory hurdles abound.
As each step in a development project is completed, overall project risk incrementally abates. Early in the cycle there are more potential obstacles and unknowns. As a project nears the “shovel-ready” construction stage, many of those potential obstacles have been addressed and resolved and there is more certainty related to execution, costs and schedule.
Below, we discuss items that are consistent across project types.
Early stage: Pre-Development
The early stage of a project focuses on due diligence, research and permitting. It is often the most variable in duration. Investing at this stage carries the greatest and most varied risks, because there are many unknowns. Some of the common steps in this phase include:
- Market analysis and feasibility studies
- Land acquisition or securing option rights to purchase land
- Environmental assessments
- Site plans, development plans, and building plans
- Some infrastructure improvements
- Arranging construction financing
Perhaps the greatest impediment to capital formation at this stage is the local jurisdiction permitting. There are usually two distinct approvals required to begin construction: land use approval and building approval.
A land use permit is a governing jurisdiction’s approval of the project on a conceptual level. Almost every jurisdiction in the country, with the notable exception of Houston, Texas, has some form of land use regulation, which provides a subject system of sorting and qualifying not only the proposed use of land (retail, industrial, residential, etc.) but also the physical characteristics of the improvements (height, density, setbacks, etc.).
The land use application process can delay a project for months or even years. For this reason, the land use permit, while not the final approval for construction purposes, is often the greatest hurdle to achieve project financing. Some items that might delay land use approval are:
- Rezoning process
- Appeals from neighbors or other interested parties
- Disputes between the developer and the jurisdiction
- An involved design process that requires multiple site plan iterations
Middle Stage: Construction
The middle stage involves constructing the improvements. Since the pre-development tasks have been completed, the project risks at this stage are greatly reduced but certainly not eliminated. Some of the common steps in this stage include:
- Vertical construction
- Project marketing
- Drawing on construction financing
- Arranging permanent financing (if not done during pre-development)
- Arranging for property manager (if not done during pre-development)
The certificate of occupancy generally marks the end of the construction phase and allows for the commencement of property operations. Like the building permit, it is based upon objective criteria regarding construction quality and is a fairly administrative process.
Final Stage: Operation
The final stage of the development process, operation, is the first stage of the building’s life. While the pre-development and construction risks may be removed by this point, obtaining tenants is still at risk. Some activities during the final stage include:
- Ongoing marketing and leasing
- Finding a buyer, if not done earlier
- Determining a hold strategy, if not selling
- Ramping up property management
- Achieving stabilization
This snapshot view highlights the risk profile of development projects over time; however, many of the same risks applicable to the purchase or refinancing of an existing building, such as sponsor solvency and expertise, economic conditions, and market factors also apply.
© Copyright 2018
All rights reserved